1.

CHAPTER 11
2.
3. PROJECT RISK ANALYSIS
4.
5. A company has developed the following cash flow forecast for their new project.
6.
7.
Rs. in million
8.
Year 0
Years 1 10
9. Investment
(400)
10.
Sales
440
11.
Variable costs (75% of sales)
330
12. Fixed costs
20
13. Depreciation(Straight line method)
40
14. Pre-tax profit
50
15. Taxes( at 20 %)
10
16. Profit after taxes
40
17. Cash flow from operations
80
18. Net cash flow
80
19.
20. What is the NPV of the new project? Assume that the cost of capital is 10 percent.
The range of values that the underlying variables can take under three scenarios:
pessimistic, expected and optimistic are as shown below:
21.
22. Underlying Variable
Pessimistic
Expected
Optimistic
23. Investment
420
400
360
24. (Rs. in million)
25. Sales (Rs. in million)
350
440
500
26. Variable cost as a percent of sales
80
75
70
27. Fixed costs (Rs. in million)
25
20
18
28. Cost of capital (%)
11
10
9
29.
30.
(a) What are the NPVs under the different scenarios ?.
(b) Calculate the accounting break-even point and the financial break-even point for the
new project.
31.
Solution:
32.
33. (a)
34.
NPVs under alternative scenarios:
35.
(Rs. in million)
36.
Pessimistic
Expected
Optimistic
37.
38.
Investment
420
400
360
39.
Sales
350
440
500
40.
Variable costs
280
330
350
41.
Fixed costs
25
20
18
42.
Depreciation
42
40
36
43.
Pretax profit
3
50
96
44.
Tax @ 20%
0.6
10
19.2

45.
46.
47.
48.
49.
50.
51.

Profit after tax

2.4
44.4
11 %

40
80
10 %

76.8
112.8
9%

NPV

- 158.53

91.6

363.95

Assumptions: (1)
The useful life is assumed to be 10 years under all three
scenarios. It is also assumed that the salvage value of the
investment after ten years is zero.

52.
53.
(b)
Accounting break even point (under expected scenario)
54.
Fixed costs + depreciation
= Rs. 60 million
55.
Contribution margin ratio
= 110/440 = 0.25
56.
Break even level of sales
= 60 / 0.25 = Rs.240 million
57.
Financial break even point (under expected scenario)
58.
59.
Annual net cash flow
= 0.8[ 0.25 x sales 60] + 40
60.
= 0.2 sales 8
61.
PV (net cash flows)
= [0.2 sales 8] x PVIFA (10%,10)
62.
= [0.2 sales 8] x 6.145
63.
64.
Initial investment
= 400
65.
66.
At the financial break even level of sales
67.
[0.2 sales 8] x 6.145 =400
68.
or Sales = ( 400/6.145 + 8) / 0.2 = 365.47 million.
69.
70. Jawahar Industries has identified that the following factors, with their respective
expected values, have a bearing on the NPV of their new project.
71.
72.
Initial investment
10,000
73.
Cost of capital
11 %
74.
Quantity manufactured and sold annually
1,000
75.
Price per unit
20
76.
Variable cost per unit
15
77.
Fixed costs
1,000
78.
Depreciation
1,000
79.
Tax rate
20 %
80.
Life of the project
7 years
81.
Net salvage value
Nil
82.
83. Assume that the following underlying variables can take the values as shown below:
84.
85.
86.
87.
88.
89.

Underlying variable
Quantity manufactured and sold
Price per unit
Variable cost per unit

Pessimistic
700
18
16

Optimistic
1,400
23
14

(a)

Calculate the sensitivity of net present value to variations in (a)

90.
91.
(a)
92.

Sensitivity of NPV with respect to quantity manufactured and sold:

93.
94.
95.
96.
97.
98.
99.
100.
101.
102.
103.
104.
106.
107.
(b)
108.
109.
110.
111.
112.
113.
114.
115.
116.
117.
118.
119.
120.
121.
122.
123.

Optimistic

Initial investment
10,000
10,000
10,000
Sale revenue
14,000
20,000
28,000
Variable costs
10,500
15,000
21,000
Fixed costs
1,000
1,000
1,000
Depreciation
1,000
1,000
1,000
Profit before tax
1,500
3,000
5,000
Tax
300
600
1,000
Profit after tax
1,200
2,400
4,000
Net cash flow
2,200
3,400
5,000
NPV at
PVIFA(11%,7years)
105. = 4.712
366
6,021
13,560
Sensitivity of NPV with respect to variations in unit price.

124.
125.
126.
127.
(c)
128.
129.
130.
131.
132.
133.

Expected

Initial investment
Sale revenue
Variable costs
Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV at
PVIFA(11%,7years)
= 4.712

Pessimistic

Expected

Optimistic

Pessimistic

Expected

Optimistic

10,000
18,000
15,000
1,000
1,000
1,000
200
800
1,800

10,000
20,000
15,000
1,000
1,000
3,000
600
2,400
3,400

10,000
23,000
15,000
1,000
1,000
6,000
1,200
4,800
5,800

- 1,518

6,021

17,330

Sensitivity of NPV with respect to variations in unit variable cost.

Initial investment
Sale revenue
Variable costs

Pessimistic

Expected

Optimistic

10,000
20,000
16,000

10,000
20,000
15,000

10,000
20,000
14,000

134.
135.
136.
137.
138.
139.
140.
141.
142.
143.

Fixed costs
Depreciation
Profit before tax
Tax
Profit after tax
Net cash flow
NPV at
PVIFA(11%,7years)
= 4.712

1,000
1,000
2,000
400
1,600
2,600

1,000
1,000
3,000
600
2,400
3,400

1,000
1,000
4,000
800
3,200
4,200

2,251

6,021

9,790

144. 3.
A project involving an outlay of Rs.5 million has the following benefits
associated with it.
145.
146. Year 1
Year 2
Year 3
147.
Cash Flow
Prob. Cash Flow
Prob. Cash Flow
Prob.
148.
(Rs. in mln)
(Rs. in mln)
(Rs. in mln)
149.
2
0.2
2
0.4
1
0.4
150.
3
0.3
3
0.3
2
0.2
151.
1
0.5
4
0.3
4
0.4
152.
153.
Assume that the cash flows are independent. Calculate the expected net
present value and the standard deviation of net present value assuming that i = 12 percent.
154.
155. Solution:
156.
157. Let At be the random variable denoting net cash flow in year t.
158.
159.
A1
=
2 x 0.2 + 3 x 0.3 + 1 x 0.5
160.
=
1.8
161.
162.
A2
=
2 x 0.4 + 3 x 0.3 + 4 x 0.3
163.
=
2.9
164.
165.
A3
=
1 x 0.4 + 2 x 0.2 + 4 x 0.4
166.
=
2.4
167.
168.
NPV =
1.8 / 1.12 + 2.9 / (1.12)2 + 2.4 / (1.12)3 5
169.
=
Rs.0.63 million
2
170.
1
=
[(2-1.8)2 x 0.2 + (3-1.8)2 x 0.3 + (1-1.8)2 x 0.5] = 0.76
171.
172.
22
=
[(2-2.9)2 x 0.4 + (3-2.9)2 x 0.3 + (4-2.9)2 x 0.3] = 0.69
173.
32
=
[(1-2.4)2 x 0.4 + (2-2.4)2 x 0.2 + (4-2.4)2 x 0.4] = 1.84
174.
2 (NPV)
175.
12
22
32
0.76
0.69
1.84
176.
=
+
+
= ------ + ------ + ----177.
(1.12)2
(1.12)4 (1.12)6 (1.12)2
(1.12)4 (1.12)6
178.
179.
=
1.98
180.
(NPV) = Rs.1.41 million

181.
182. 4.
A project has a current outlay of Rs.30,000. The expected value and standard
deviation of cash flows are:
183.
184.
Year
Expected Value
Standard Deviation
185.
186.
1
Rs. 18,000
Rs. 7,000
187.
2
20,000
4,000
188.
3
20,000
6,000
189.
4
10,000
2,000
190.
191.
The cash flows are perfectly correlated. Calculate the expected net present
value and standard deviation of net present value of this investment, if the risk-free
interest rate is 6 percent.
192.
193.

Solution:
194.

Expected NPV
195.
4
At
196.
=
- 30,000
197.
t=1 (1.06)t
198.
199.
=
18,000/(1.06) + 20,000 / (1.06)2 + 20,000 / (1.06)3
200.
+ 10,000 / (1.06)4 30,000
201.
202.
=[ 18,000 x 0.943 + 20,000 x 0.890 + 20,000 x 0.840 + 10,000 x0 .
792]
203.
- 30,000
204.
= 29,494
205.
206.
Standard deviation of NPV
207.
4
t
208.

209.
t=1 (1.06)t
210.
211.
= 7,000/(1.06) + 4,000 / (1.06)2 + 6,000 / (1.06)3
+ 2,000 / (1.06)4
= 7,000 x 0.943 + 4,000 x 0.890 + 6,000 x 0.840 + 2,000 x0 .792
212.
= 16,785
213.
214. 5.
The expected cash flows of a project are given below:
215.
216.
Year
Cash Flow
217.
0
(50,000)
218.
1
10,000
219.
2
30,000
220.
3
20,000
221.
4
20,000
222.
5
10,000
223.

224.
What is the net present value of the project under certainty equivalent method,
if the risk-free rate of return is 8 percent and the certainty equivalent factor behaves as
per the equation: t = 1 0.08t

225.
1. Solution:
226.
2.
227.
3.
228.
7. Certain
229.
4. Y
6. Certainty
ty
8. Disco
230. e
Equivalent
Equival
unt
231. a
5. Cash
Factor: t =1
ent
Factor 9. Presen
232. r
Flow
- 0.08t
value
at 8%
t Value
233.
10. 0 11. -50000
12. 1
13. -50000
14. 1
15. -50000
234.
16. 1 17. 10000
18. 0.92
19. 9200
20. 0.926
21. 8519
235.
22. 2 23. 30000
24. 0.84
25. 25200
26. 0.857 27. 21596
236.
237.
28. 3 29. 20000
30. 0.76
31. 15200
32. 0.794 33. 12069
238.
34. 4 35. 20000
36. 0.68
37. 13600
38. 0.735
39. 9996
239.
40. 5 41. 10000
42. 0.6
43. 6000
44. 0.681
45. 4086
240.
50. NPV
241.
46. 242. 47.
48.
49.
=
51. 6266
243.
244. 6.
Cryonics Limited is planning to launch a new product, which can be
introduced
initially in Western India or in the entire country. If the product is
introduced only in Western India, the investment outlay will be Rs.30 million. After two
years, Cryonics can evaluate the project to determine whether it should cover the entire
country. For such expansion, it will have to incur an additional investment of Rs.25
million. To introduce the product in the entire country right in the beginning would
involve an outlay of Rs.50 million. The product, in any case, will have a life of 5 years,
after which the plant will have a zero net salvage value.
245. If the product is introduced only in Western India, the demand would be high
or
246. low with probabilities of 0.8 and 0.2 respectively and annual cash inflows of
Rs.10 million and Rs.6.25 million respectively.
247. If the product is introduced in the entire country right in the beginning the
demand would be high or low with probabilities of 0.6 and 0.4 and annual cash inflows
of Rs.20 million and Rs.12.5 million respectively.
248. Based on the observed demand in Western India, if the product is introduced
in the entire country the following probabilities would exist for high and low demand
on an All-India basis.
249.
250.
251.
All India
252. Western India
253. High demand
Low demand
254.
High demand
0.90
0.10
255. Low demand
0.40
0.60
256.
The hurdle rate applicable to the project is 12 percent.
257.
(a) Set up a decision tree for the investment situation of Cryonics Limited.
258.
(b) Advise Cryonics Limited on the investment policy it should follow.
Support
your
advice with appropriate reasoning.
259.

260.

261.
262.
Working 263.
:
264.
265.
266.
57.
267.
58.
268.
59.
269.
60.
270.
61.
271.
272.
63.
273.
64.
274.
275.
0.1
276.
66.
277.
278.
279.
280.
70.
115. 281.
D1 282.
72.
283.
12.5
284.
73.
285.
74.
286.
75.
287.
76.
288.
77.
79.

85.
86.
87.
88.
89.
90.
91.
92.
93.
94.

HD: 20 M
All 100.
India
-25
62.

HD
10 103.
M

0.9

101.
102.

LD : 12.5

C1
107.
Western
108. 3
India
3.3
-30
106.

67.

0.8
LD
112.

D6.25
3
0.2

Western
10
HD : 20 M
109. India
0.40
C4
All India
110.
111. - 25
LD

Western
116.
117.

C2

0.60
India

HD : 20M

6.25

289.61.29
0.6
290.
119.
All India
291.
292.
- 50
293.
294.
LD : 12.5
295.
84.
296.
0.4
297.
298.
299.
At D2 the payoffs of the All India
and Western India alternatives are:
300.
All India :
19.25 x PVIFA
(3,12%) - 25 = 21.2 million
301.
Western India : 10 x PVIFA (3,12
302. %) = 24.0 million
Since the Western India option303.
is more profitable, the All-Indian option is truncated
At D3 the payoffs of the All India
and Western India alternatives are:
304.
All India :
15.5 x PVIFA (3,12%)
305. 25 = 12.2 million
Western India 6.25 x PVIFA (3,12%)
306. = 15.0
307.
308.
118.

120.
121.
122.
123.
124.
125.
126.
127.
128.
129.
130.
131.
132.
133.
134.
135.
136.
137.
138.
139.
140.

309.
310.
311.
312.
313.
314.
At C1 the expected payoff is315.
:
316.
0.8 [ 10 x PVIFA (2,12%) +317.
24 x PVIF (2,12%)]
318.
+ 0.2 [ 6.25 x PVIFA (2,12%)
+ 15 x PVIF(2,12%)]
319.
320.
= 0.8 [ 10 x 1.736 + 24 x 0.797]
321.
322.
+ 0.2 [ 6.25 x 1.736 + 15 x 0.797]
323.
324.
= 0.8 [ 17.36 + 19.13]
325.
326.
+ 0.2 [ 10.85 + 11.96] = 29.19
327.+ 4.56 = 33.75
328.
At C2 the expected payoff is329.
:
330.
[ 20 x 0.6 + 12.5 x 0.4 ] x PVIFA
331. (5,12%)
332.
= 61.29
333.
334.
The appropriate investment
335. policy is to choose the all-India alternative and continue
336.
7.
Magna Oil is wondering whether to drill oil in a certain basin. The cost of drilling a 500 metre well is Rs.20 million. The
probability of getting oil at that depth is 0.6. If oil is struck, the present value of oil obtained will be Rs.30 million. If the well turns out to
be dry, Magna can drill another 500 metres at a cost of Rs.25 million. If it does so, the probability of striking oil at 1000 metres is 0.5 and
the present value of oil obtained will be Rs.55 million.
337.
338.
Draw the decision tree. What is the optimal strategy for Magna Oil.
339.

340.
341.
342.
343.
344.
345.
346.
347.
348.
349.
350.
351.
352.
353.
354.
355.
356.
357.
358.
359.
360.

Working:
Oil

Oil
30

55

0.6

0.5

Drill 500

Drill
19

27.5

-20

-25

-1

Dry

Dry

0
2.5

0.4
Do nothing
0
0
Do nothing

Do nothing